A NOTE ON EXITS
When I started Return Path in the froth of the Internet boom in 1999, someone told me I should hire a writer to follow me around and record everything that happened in the formative weeks and months of the business. The person actually said to me, “You can publish a book about how quickly you built and sold the business—it will be called Ready, Set, Exit.”
One of the most unfortunate stereotypes about startup CEOs is that we’re only in it for the exit: the business equivalent of real estate investors who flip a dozen properties a year. That may describe some startup CEOs but it shouldn't describe you.
There is no such thing as an exit strategy for a great company. There are only growth strategies, customer development strategies and global expansion strategies. Great companies might be bought but they're rarely sold. Work hard to build a great company and you might get bought—at an amazing price. Work hard at selling your company and somebody might pick up the scraps.
Exits and Liquidity
Tim Miller is the chairman and CEO of Rally Software (which completed a successful initial public offering while I was writing this book) since 2003 and is singularly focused on making Rally Software a great company. Rally and Return Path are companies that have been leading parallel lives in the Boulder, Colorado, area for years and Tim and I frequently compare notes. Like all great entrepreneurs, Tim's focus has been on growth rather than exits—but that doesn't mean he hasn't given the latter considerable thought.
For a startup entrepreneur, a strategic sale represents a life-altering opportunity to build a personal balance sheet that provides a safety net for career and family. First-time entrepreneurs in this scenario often have little or no assets in the bank—other than equity in the company. As a result, many people simply pick a sale price that satisfies a financial goal then proceed to focus on reaching that valuation. This “number” is a useful goal to set and should be reevaluated annually as the business progresses. When the thrilling opportunity arises to be able to sell for the “number,” it's hard to argue against selling the business, putting the money in the bank and using it to fund your next startup. Once you have got that level of safety and security, you can take another run at building something truly exceptional.
Determining the right number isn't always easy. My advice is to think about the company in terms of a balance sheet number versus an income statement number. Let's look at a very simple income statement example. A company generating 5 percent free cash flow per year from total revenue of $10 million annually at a steady state can generate $1.5 million in cash over a three-year period. However, analyzing the assets in a balance sheet approach shows that the $10 million run rate business could potentially be sold for $10 million, even at a modest 1× price/sales multiple. The question you have to ask is which would you prefer from a financial perspective—$500,000 per year with all the risk associated with running a going concern or $10 million in cash that you could put in the bank?
In the meantime, remain laser focused on growing the company; it will be compound in value as it grows. In the preceding example, the $10 million run rate business growing at 100 percent per year could generate $500,000 year one, $1 million in year two, $2 million in year three, and so on. In this compound growth example, the cash for shareholders would be $3.5 million after three years. If the company were sold for a 1× price/sales multiple in year three, the sale would be worth $40 million.
There are several factors to consider when contemplating a sale. First of all, there will almost always be a better price/sales multiple if the buyer initiates the conversation about acquisition. They will most likely have a more optimistic perspective on the company if they discover the business through a strategic focus on building their company, as opposed to reacting to a company that's looking to sell. Great outcomes are bought, not sold.
The question is how to position the company to be bought for a higher multiple. First and foremost, grow and invest in the business for the long term. There are no shortcuts to building a truly valuable business. Also, make sure to build relationships with strategic partners who might be potential buyers. If and when they come to talk about a potential sale, engage in the conversation so they know about your company but consider a sale only if they offer a significant premium to the true balance sheet value of the company. The premium for a 100 percent growth company would, of course, be much larger than the premium for a 10 percent growth company—so grow, grow, grow.
Of course, a sale isn't the only successful outcome for a startup. The other is to remain a long-term stand-alone company and eventually go public.
The downsides of being under public investor scrutiny are outweighed by the upsides of continuing to run a successful company. The only way to reach that potential is to scale and grow at a rate of at least 25 to 30 percent annually. When growth slips, so does the likelihood of an eventual initial public offering.
Given the active M&A market for emerging growth companies, it is extremely difficult to build long-term stand-alone company, especially in the tech sector. The best way to reduce the chances of an unwanted sale while maximizing shareholder value is to grow at the fastest rate possible. In that case, only a premium valuation would cause shareholders to opt for a strategic sale.
However, these two outcomes aren't mutually exclusive. It's always good practice to consider the possibility of an acquisition before or even after an IPO. Regardless of whether you eventually sell, go public or do both, the imperative for startup CEOs remains the same: grow!
Tim Miller, CEO, Rally Software
FIVE RULES OF THUMB FOR SUCCESSFULLY SELLING YOUR COMPANY
Return Path is the first company I've built and we haven't sold it. I don't have experience as a CEO in selling a company, though I did live through and work on the sale of MovieFone to AOL in 1999 and I've helped many CEOs work through acquisitions of their own companies. I try not thinking much about exits as they pertain to Return Path but I couldn't help formulating a few best practices in case it ever comes up:
- Optimize the value of the transaction. Always have multiple bidders (see my comments about a BATNA in Part Three). You can literally double or triple the deal price that way. If there is ever a time for financial engineering, it's now. I've seen deals with collars and no caps—brilliant.
- Find the company a good home. It's your baby. You do want to find a good home for it. This could be in conflict with optimizing the value of the transaction, so be prepared to factor that in—up to some level.
- Balance authenticity and transparency with being smart about internal communications. Deals fall through all the time. Don't overcommunicate too early or you risk sending the message that you're looking for an exit when all you were doing was exploring an option.
- It ain't over till it's over. Again, deals can fall through at any moment. Keep running your business, fully engaged, until the ink is dry.
- Once it's over, it's over. You're still the CEO but now you have a (new) boss. “Even though the deal was called a merger,” I once heard Ted Leonsis tell the MovieFone founders, “please remember that you have been acquired.” Figure out how to best set your team and products up for success in the new environment, regardless of how long or short you plan to stay at the new company.
Finally, remember that going public is not an exit. It's the next stage in your company's evolution and in fact it requires that you and your senior team double down on the business and your jobs for several years.